Understanding how to mitigate risk is as important as ever in 2022
Tail risk in capital markets refers to the risk of large financial losses from an unforeseen and rare event. Typically investors like to model the probability of outcomes for their prospective investments based on past performance. This logically makes sense, but backward-looking models don’t account for the unforeseen and sadly the unforeseen can inflict irreversible damage on a portfolio. This is an area in the market that doesn’t garner a lot of attention, but many have been devastated by it. Retirees have lost their entire savings, advisors have been fired, hedge funds put out of business. What if we had effective ways to mitigate unforeseen tail risk? What if there was a way to participate in the market while also aggressively protecting the downside without giving up too much?
Let’s start with some background on why tail risk exists and why we think accounting for it now is as important as ever. The ecosystem of financial products, brokers, liquidity providers, exchanges, matching engines and clearing agents that define how U.S. equities are traded is not static. Market microstructure has changed tremendously over the past seven years. This change has led to an added reflexivity in the way assets are traded. There are several structural changes that can potentially lead to a large deleveraging in the near future. Unfortunately, we can’t cover everything in this article. If you are interested in learning more about these structural changes, they are discussed in great detail in our white paper.
With the background information on why a tail risk event is certainly possible, let’s dive into its effect on portfolios and how to mitigate catastrophic damage. Obviously, a rapid decline in equity prices is adversarial for any equity investor. What is less obvious (but certainly important) is that bonds, while typically viewed as the more safe portion of a traditional 60/40 portfolio, have been correlated with equities during recent market crashes, along with “defensive” stocks and commodities.
Above, this chart shows the correlation of S&P 500 with bonds and gold.
Traditional bond allocations and “portfolio hedges” not only fail to mitigate risk historically but they have actually increased it during extreme crashes. So why is it that so many people continue to depend on these “hedges” to protect their equity exposure? As tail risk managers, we have heard nightmare stories about investors losing money during moments of market volatility. Financial engineering has opened up the door to have investors rely on metrics that can be misleading and harmful. If there is one thing that March 2020 reminded us, it is that during a real exogenous event, bonds can crash, defensive stocks can crash, commodities can crash, and normal market behavior gets tossed out the window. Those hedges are not reliable enough to protect and grow a portfolio. The purpose of a hedge is not to add additional risk to the portfolio, but to protect it.
Below is the performance of a vanilla 60/40 stock/bond portfolio compared with the performance of a blend of equities & a managed tail risk hedge. There is a reason that equity beta plus a tail hedge has been one of the best-performing vanilla blends over the last decade.
We often hear investors say things like “I am a long-term investor, I have no plans to sell.” Although this may sound like a bulletproof investment philosophy, it is actually a suboptimal game plan. A massive tail risk event’s effect on a portfolio incurs a phenomenon known as variance drag. Variance drag refers to the fact that a portfolio with high volatility will underperform a portfolio with low volatility even if they both have the same average arithmetic return. For example, a portfolio with $100 that suffers a 50% loss, and then a 50% gain will end up with $75 while a portfolio with a 10% loss than a 10% gain will end up with $99. If you are fully allocated long to the broad market when a -40% event happens you subject yourself to substantial variance drag.
To further see the detrimental effects of tail risk, look at the chart below that shows S&P performance from Jan. 1, 2000 through the end of 2021. And then look at the same performance after removing the five 20% rolling 30-day drawdown periods that occurred during that period. The S&P has done exceptionally well since 2000 but returns would have quadrupled if the five 20% drawdown periods were omitted. So the next time someone tells you “I don’t care what the market does, I’m a long-term investor,” be sure to remind them that it took tech investors 15 years just to break even after the 2000 tech crash (NDX March 2000 – April 2015). Other investors multiplied their wealth tenfold during this time frame. This is the power of using a tail risk hedge to your advantage.
Considering all the deleterious effects of a tail event, it is worthwhile to figure out how best to prevent it from hitting your portfolio. In our opinion, the best way to do this is via a managed long volatility allocation that leverages the extreme optionality in the derivatives market. This is the exact specialty of the Ambrus Group and it is the primary way in which we aim to help investors.
It’s important to note that implementing a tail risk hedge is not as easy as buying puts on the S&P 500 or calls on the VIX. Execution, structuring, and timely monetization all play a part in this process. Adding a small allocation to instruments like variance swaps, for example, could have vastly increased the payout during a large crash.
There is some concern that traditional long volatility allocations have an inherent bleed. We often encounter white papers that discuss the negative drag that comes with a tail risk hedge. This is true but if managed well, the incredible convexity of volatility derivatives makes it so it may only take a small allocation to be in position for a possibly substantial gain. If a 5% portfolio allocation only bleeds 5% annually in years without a tail event, it isn’t a substantial drag on a portfolio, but if it returns 250% in a tail event, it can mitigate tail risk while also providing capital to buy assets now trading at fire sale prices. This is why it’s important that the investor relies on a managed tail risk hedge.
Consumers purchase cars, homes, watches, and insure them without thinking twice. In our opinion, it only makes sense to insure one of the single biggest drivers of many individuals’ net worth, their investment portfolio.
